Pension plans, such as defined benefit plans, can be costly to a sponsoring company due to the funding obligations and also affect the perceived health of the company's balance sheet. Pension plans are often seen as a liability, and by having them, a certain amount of risk is inherent.
For example, funding shortfalls are problematic. Legislation exists to anticipate and remedy them, and insurance companies exist to cover a company's liability should the company underfund the pension plan. An estimate of the aggregate pension funding shortfall of the S&P 1500 at year-end 2011 was $484 billion (representing a 75% funding level), up a staggering $544 billion from year-end of 2007 when the aggregate funding level was 104%. By putting downward pressure on pension liability discount rates, the current low interest rate environment has been a major contributing factor to this increase in unfunded pension liabilities. Treasury yields, a major component of pension liability discount rates, ended 2011 at near record lows and the interest rate of the Citigroup Pension Liability Index ended 2011 at a record low 4.40%.
Recent survey data suggest that many plans may be trending dangerously close to the critical 80% funding level threshold under the Pension Protection Act (“PPA”). Plan sponsors who find themselves in this position might want to consider making additional contributions to their plans in order to avoid the penalties that could result if they fall below this level. These penalties include a restriction on lump sum distributions to no more than 50% of the value of the participant's accrued benefit (lump sum distributions are prohibited if a plan's funding level falls below 60%); possible designation of a plan as “At Risk” if its funding level is also less than 70% based on more conservative “worst-case scenario” assumptions—contribution requirements are higher for “At Risk” plans; and/or additional disclosure and filing requirements, including (1) a notice to participants in the event lump sum distributions are restricted and (2) a “4010 filing” of financial and actuarial information when the funding level falls below 80%.